U.S. investors may be focused on what the Fed will do and say, but they should be paying more attention to what happens in Japan, and Down Under

U.S. stock investors should look toward the Far East and Down Under for guidance next week.

The Federal Reserve, which meets next week to unveil its interest-rate policy for the next six weeks, will undoubtedly dominate the headlines - but it isn't likely to be the most important central bank for U.S. investors. The Bank of Japan will get that honor.

The financial markets have rapidly repriced the odds over the past week that Japan's central bank will raise interest rates, following hawkish comments from a few of the BoJ's policymakers. The repricing has coincided with a sharp strengthening of the Japanese yen across currency markets.

A stronger yen has not yet affected most U.S. investors, but there are more reasons that could change. Historical market relationships suggest that if the BoJ comes across as being hawkish, or prone to keep hiking rates, market turmoil could follow.

The case for a hawkish Bank of Japan

What the Fed will do next week has become pretty clear-cut after Friday's consumer-inflation data.

And based on current market conditions, the case for the yen strengthening further is also strong, as is the case for the Bank of Japan to not only raise rates as soon as Sept. 18, but potentially raise them multiple times in the future. Rising interest rates tend to make that currency more attractive to yield-seeking investors.

On Friday, the yen strengthened 0.5% against the dollar in morning trading, and has rallied nearly 2% this week.

Overnight index swaps - a financial contract between counterparties used to manage interest rate risk - imply an overnight rate of approximately 1.18% for the Sept. 18 BoJ meeting in recent trading, equivalent to roughly a 72% probability of a quarter-percentage-point hike, to 1.25% from 1%. The implied rate for the Oct. 30 meeting stands at 1.28%, suggesting some additional tightening is priced beyond September.

Implied Japanese overnight rate

The first leg of yen strength was driven by a BoJ rate hike and a round of government intervention aided by the U.S. Treasury Department in late July. The second leg lower in the U.S. dollar-Japanese yen rate (USDJPY) since the start of September has been driven by expectations that a rate hike would come at next week's meeting.

What will matter most is what the BoJ signals about the path of future rate hikes, which it will lay out in the postmeeting communication and press conference. That guidance could determine whether the yen's rally continues.

Implied overnight rate vs. dollar-yen rate.

The bank has ample reason to remain hawkish. Japan's 2-year real yield is approximately negative-2%, while the inflation break-even measure shown is above 3.3%.

These readings suggest that monetary conditions remain accommodative despite the rise in nominal yields, strengthening the case for further BoJ rate hikes. Higher nominal yields, lower inflation expectations, or a combination of both would raise real yields and make monetary conditions less accommodative.

Global impacts

A hawkish BoJ that commits to further rate hikes, and perhaps more importantly, at a faster pace, could lead to the Japanese yen strengthening further, which would likely ripple across global markets. One gauge is the relationship between the Australian dollar and the Japanese yen (AUDJPY), or AUD/JPY. U.S. investors should care about this currency pair because markets typically see it as a strong risk-on/risk-off gauge. Currently, AUD/JPY is flashing a warning sign.

The region between 109 and 110 on the AUD/JPY technical chart marks an important support area that, if breached, could lead to a further decline in AUD/JPY and potentially push global-markets volatility higher.

Australian dollar vs. Japanese yen

Since 2008, the 26-week rolling correlation between AUD/JPY and the Cboe Volatility Index VIX, which tracks the expected volatility of the U.S. stock market, has been predominantly negative, meaning the AUD/JPY has generally tended to fall when the VIX rises.

But around early March, just after the Middle East conflict began, the relationship turned positive as market volatility increased and bets grew that higher oil prices would hurt the Japanese economy, weakening the yen even as the VIX rose. But more importantly, the relationship has resumed its inverted nature. A break below technical support alongside rising BoJ rate expectations could signal growing risk aversion across global markets.

And that would be a bad sign for U.S. stocks.

AUD/JPY compared with the Cboe Volatility Index

While U.S. investors focus on the Fed, the bigger surprise could come from the Bank of Japan. A rate hike, coupled with a hawkish message - or guidance pointing to a faster pace of tightening-could extend the yen's rally and increase the risk of a broader unwind in yen-funded positions. A break below 109-110 in AUD/JPY would be one warning sign to watch.

Michael Kramer is the founder of Mott Capital Management and a long-only investor focused on macro themes. He analyzes long-term macro trends and short-term market risk using technical analysis, fundamentals and options-market positioning. See here for further disclosures.

-Michael Kramer